Arguing Over a Nonexistent Bubble

(Image: CartoonArts International / The New York Times Syndicate)Noah Smith, who is a better human being than I am, recently waded through an anti-Krugman rant to find an interesting nugget: the claim that money is a bubble.

"Is money fundamentally worth nothing more than the paper it's printed on (or the bytes that keep track of it in a hard drive)?" Mr. Smith, an assistant professor of finance at Stony Brook College wrote on Oct. 21. "It's an interesting and deep question. But my answer is: No."

It isn't, of course; but my explanation of why it isn't is a bit different from his, and has wider implications. I'd start by asking, what do we mean when we talk about bubbles? Basically, I'd argue, we mean that people are basing their decisions on beliefs about the future that are based on recent experience but can't be fulfilled. For example, people buy houses because they expect home prices to keep rising at a pace that would eventually leave nobody able to buy a first home.

Bubbles don't have to involve prices. You can have a local construction boom driven by rapid growth in an area's population and employment, when the main thing driving that rapid growth is ... the local construction boom, which will eventually collapse when enough houses are completed. The point, whether prices are involved or not, is that the expectations of individuals add up to an aggregate impossibility.

This sounds a lot like what happens in a Ponzi scheme, where people are relying on an ever-growing number of new subscribers — such plans are doomed to disaster when the pool of potential suckers runs dry.

Is fiat money a bubble in this sense? Not at all. It's true that green pieces of paper have no intrinsic value (except that they can be used to pay taxes, which is actually important), so that my willingness to accept green paper from you is based only on my belief that I can, in turn, hand that green paper over to someone else. But there's nothing to prevent that process of monetary circulation from going on forever.

So what is fiat money? It is, as the economist Paul Samuelson put it, a "social contrivance." It's a convention, which works as long as the future is like the past. Obviously, such conventions can break down - but then so can things like property rights. In fact, you could argue that almost every asset in a modern economy owes its value to social convention; green pieces of paper could become worthless, but then so could any paper claim, which is, after all, worth something only because laws say it is - and laws can be repealed.

And once you realize that a social convention is not at all the same thing as a bubble, several related fallacies fall into place.

Take the common claim on the right that Social Security is a Ponzi scheme because the system has few real assets. It's true that Social Security is mainly a system in which each generation pays for the previous generation's retirement, in the expectation that it will receive the same treatment from the next generation. But like monetary circulation, this process can go on forever; there's nothing unsustainable about it (yes, demography, but that's about the levels of taxes and benefits, not the fundamental nature of the scheme). So there's nothing Ponziesque at all.

A final thought: the notion that there must be a "fundamental" source for money's value, although it's a right-wing trope, bears a strong family resemblance to the Marxist labor theory of value. In each case what people are missing is that value is an emergent property, not an essence: money, and actually everything, has a market value based on the role it plays in our economy.

Arguing Over a Nonexistent Bubble

(Image: CartoonArts International / The New York Times Syndicate)Noah Smith, who is a better human being than I am, recently waded through an anti-Krugman rant to find an interesting nugget: the claim that money is a bubble.

"Is money fundamentally worth nothing more than the paper it's printed on (or the bytes that keep track of it in a hard drive)?" Mr. Smith, an assistant professor of finance at Stony Brook College wrote on Oct. 21. "It's an interesting and deep question. But my answer is: No."

It isn't, of course; but my explanation of why it isn't is a bit different from his, and has wider implications. I'd start by asking, what do we mean when we talk about bubbles? Basically, I'd argue, we mean that people are basing their decisions on beliefs about the future that are based on recent experience but can't be fulfilled. For example, people buy houses because they expect home prices to keep rising at a pace that would eventually leave nobody able to buy a first home.

Bubbles don't have to involve prices. You can have a local construction boom driven by rapid growth in an area's population and employment, when the main thing driving that rapid growth is ... the local construction boom, which will eventually collapse when enough houses are completed. The point, whether prices are involved or not, is that the expectations of individuals add up to an aggregate impossibility.

This sounds a lot like what happens in a Ponzi scheme, where people are relying on an ever-growing number of new subscribers — such plans are doomed to disaster when the pool of potential suckers runs dry.

Is fiat money a bubble in this sense? Not at all. It's true that green pieces of paper have no intrinsic value (except that they can be used to pay taxes, which is actually important), so that my willingness to accept green paper from you is based only on my belief that I can, in turn, hand that green paper over to someone else. But there's nothing to prevent that process of monetary circulation from going on forever.

So what is fiat money? It is, as the economist Paul Samuelson put it, a "social contrivance." It's a convention, which works as long as the future is like the past. Obviously, such conventions can break down - but then so can things like property rights. In fact, you could argue that almost every asset in a modern economy owes its value to social convention; green pieces of paper could become worthless, but then so could any paper claim, which is, after all, worth something only because laws say it is - and laws can be repealed.

And once you realize that a social convention is not at all the same thing as a bubble, several related fallacies fall into place.

Take the common claim on the right that Social Security is a Ponzi scheme because the system has few real assets. It's true that Social Security is mainly a system in which each generation pays for the previous generation's retirement, in the expectation that it will receive the same treatment from the next generation. But like monetary circulation, this process can go on forever; there's nothing unsustainable about it (yes, demography, but that's about the levels of taxes and benefits, not the fundamental nature of the scheme). So there's nothing Ponziesque at all.

A final thought: the notion that there must be a "fundamental" source for money's value, although it's a right-wing trope, bears a strong family resemblance to the Marxist labor theory of value. In each case what people are missing is that value is an emergent property, not an essence: money, and actually everything, has a market value based on the role it plays in our economy.